A major news story this past week came from Propublica, centered around how PayPal founder Peter Thiel was able to amass a $5 Billion dollar Roth IRA account. Why is this big news? Because Roth IRA accounts are tax free, meaning that Mr. Thiel will not send a dime of that $5 billion fortune to Uncle Sam when he starts withdrawing from that account.
That's right, you read that correctly. 5 billion bucks, tax free. Now, there has been a number of stories recently coming out about the need for a more fair tax system, especially when it comes to the top .01% of the uber-wealthy in America. There is undoubtedly some flaws in the system that need to be addressed, especially when it comes to how billionaires are able to take advantage of paying little to no income tax while running some of the largest and profitable corporations in the world. However, I do not believe this specific story and unique circumstance from Peter Thiel should be cause for major change to the tax policy of the Roth IRA. And before we toss our hands up in the air and throw the BonkerBeat guy under the bus for thinking he's defending billionaires, hear me out.
What is a Roth IRA? Why should I care?
Firstly, I would like to briefly discuss what exactly a Roth IRA is. I believe it is the single most important investment tool available to Americans today. A Roth IRA, which stands for "Individual Retirement Account," differs from the traditional IRA or 401k retirement account. Let me explain the differences between the two-
A traditional retirement account, such as a 401K or IRA, will deposit money into your account usually from your paycheck, BEFORE the money is taxed by the government. There is a $19,500 maximum annual contribution limit to 401ks, and a $6,000 annual contribution limit to the traditional IRA. This money is deposited into your account, and invested for you in mutual funds, stocks, bonds, and other investment assets. As these funds increase in value over time, your 401k or IRA balance will increase with it. You will not pay any taxes on these gains, UNTIL you start withdrawing this balance at your retirement age. You will pay the tax rate of whatever your withdraw in total income for that year. So if you withdraw $30k from your 401k, you will pay the income tax associated with that tax bracket.
With a Roth IRA, you invest your money into the Roth IRA AFTER you have paid your taxes on your income. Your money is invested in the same types of assets, whether it be mutual funds, stocks, or government bonds, and your money grows tax free. It is worth noting that you can invest in any type of stock of your choosing*. The difference here is that when you go to withdraw your money from your Roth IRA at retirement (*59 1/2 years old is the penalty-free withdraw age) you do not owe any money to the government, since they have already taxed that money before you put it in your account. The one kicker to the Roth IRA is that there is only a $6,000 maximum annual contribution limit, due to the extremely advantageous tax policy associated with it. Let's run some numbers to show how powerful the Roth IRA can be for investors:
Let's assume you started contributing your $6,000 a year into your Roth at the age of 25. If $6,000 sounds like a lot, try thinking about it by breaking it up into $500/ month. Lets also assume you had a starting balance of $0, and earned on average over the next 40 years an 8% return on your invested money. You would reach retirement with roughly a $1.5 million account balance. And the best part is, when you retire and start hitting that money, it will be TAX FREE! Check out the chart below comparing these contributions with the same inputs compared to a regular taxable savings account:
Pretty awesome right?
The Roth is a relatively new investment vehicle, as it was only created in 1998. So many of those younger people who began contributing to their Roth IRAs when it was invented have yet to even tap into their nest egg-which has been growing tax free for over 20 years in some instances. Although it was created more than 20 years ago, we are still experiencing how these new tax policies and guard-rails will play out over time. (Thus why we see situations like Thiel's pop up from time to time.)
Peter Thiel's Situation:
Okay, now that we have everyone all jazzed up about Roth IRA's and how awesome they are, let's take a closer look at the Peter Thiel situation.
Peter Thiel was one of the founders of PayPal. (*If you aren't familiar with the "PayPal Mafia" you gotta check out this graphic below showing some of the most recognizable names and companies that came out of the early days of PayPal.*)
Hell of a list huh?^ Anyway, Thiel was a founder of the company, meaning he had equity in the business he helped start up, and thus was given the opportunity to purchase shares before the company went public. The Propublica article writes, "Thiel paid $0.001 per share — yes, just a tenth of a penny — for 1.7 million shares. At that price, he was able to buy a large stake for just $1,700." Thiel made this purchase in 1999, during the midst of the "dot com bubble".
These shares would later grow to astronomical multiples of what Thiel had purchased them for. In 2002, PayPal was purchased by internet giant eBay for $1.5 billion, and Thiel elected to sell his equity in the company for a staggering $28.5 million. Since these shares were purchased and sold within the Roth IRA account, the $28.5 million dollar pay-day was tax free, and the gains were allowed to be reinvested into other companies and opportunities that Thiel would later become a part of.
Over the course of the next 15 years, Thiel was essentially able to use his Roth IRA as his own private investment bank, buying shares of companies such as Facebook, Palantir, and other tach companies in their early development phases. As these giants grew in size and value, Thiel would cash in as the tech revolution unfolded across Silicon Valley in the 2000's. Since the transactions were kept inside his Roth IRA, he was not subject to the 20% capital gains tax and 9% California state tax.
Over the course of his investing career, Thiel has been reported to have grown that initial balance of $1,700 from his founder shares at PayPal to over $5,000,000,000 in 2020. This understandably has some people fired up about fairness of the system, and again has billionaires in the cross-hairs of politicians and lawmakers looking to make changes to the tax system.
The Action That is Needed:
Yes, some of Wall Street and Silicon Valley's biggest names have undoubtedly played the system of the Roth IRA, and are not using it the way lawmakers had intended for it to be used. And if this article by Propublica was meant to address this issue then fine, let them have their moment and applaud them for shining a light on a loophole that needs closing. I think there can be fair and reasonable adjustments to the tax policy of Roth IRAs, that still allow for tax-free growth and withdrawal, up to a certain point. There is currently no limit to the amount of $ that can grow within the account, and that needs to be adjusted. I would bet there is some sort of limiting policy that comes from this story down the road, and I would be happy to see that so these types of stories don't continue to pop up. However...
I just hope that the policy changes that come from the actions of the few, do not hurt the many.
Roth IRA's tax advantages help many middle class Americans have a shot at financial freedom and retirement. And although I say many, I think this article can hopefully lead to many more. According to AmericanIRA.com, only 19% of U.S. households currently own a Roth IRA. That number is far too low. A huge reason that I set out to start writing the BonkerBeat was to help promote financial literacy and investing education. I believe there is a huge gap especially in my age demographic when it comes to understanding personal finances and investing.
When I saw this story break this week, I was PUMPED to see my Twitter feed show #RothIRA as a trending topic. Although we were competing with #FreeBritney, ultimately a lot of people were exposed to learning about what a Roth IRA is this past week that otherwise wouldn't have before if it was not for this piece by ProPublica. Political aspirations aside, I believe this article was largely impactful in promoting the potential power of using investment vehicles and opportunities that are available to you.
No, you most likely do not have access to purchasing shares of the next PayPal at fractions of a penny per share, but you do have access to opening a Roth IRA, and having that money grow and compound annually tax free over time. If you can manage to, I highly encourage opening one and just start throwing $50 a month into it. It might not seem like a lot now, but beginning to build investing behaviors and learning about the power of investing through experience will pay dividends down the road.
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*Although I wouldn't recommend it, all you Robinhood investors, yes you can 🚀🌖💎🙌 inside your Roth IRA if you so choose. As long as you keep your money inside the account and do not withdraw it until you are 59 1/2, you will not have to pay any penalty fees or taxes on the money you made from your investments. *
Thanks for reading! If you haven't yet, check out the Bonker Bookshelf for what I'm reading this week:
Great post and completley agree with the sentiment. I personally love my Roth IRA! You're doing folks our age a service for writing this sort of thing out. I'd make two tweaks to your statement, "A traditional retirement account, such as a 401K or IRA, will deposit money into your account usually from your paycheck, BEFORE the money is taxed by the government." Generally, Traditional IRAs are not funded via payroll deduction but rather via contribution much like a Roth IRA (though their contributions are tax-deductible). I'd also note that Roth 401(k)s (which I'd consider a subset of 401(k)s more generally) are funded via payroll deduction but contributions are still subject to income tax (i.e. money is not deposited 'BEFORE…